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Illinois Office of the Governor has released a video aimed at school kids. It’s subject: the importance of paying workers their government pensions. It’s meant to get Illinoisans excited about pension reform. Illinois has the worst pension system in the country. The pension liability grew by $12 billion this year. According to Illinois official accounting the unfunded liability is $100 billion. Under market valuation the unfunded liability is over $200 billion. The Civic Federation calls the system, “Unfixable.”

Enter, Squeezy the Pension Python.

Cute.

There’s some history about the Romans, the American Revolution, and World War I. There’s a basic message about why we (i.e. government on your behalf) should make sure promises are kept. But, not surprisingly, this video totally misdiagnoses why the pension fund is running on empty. I didn’t expect it to contain much in the way of discount rates. Instead the blame is shifted to yesterday’s politicians and the 2008 Wall Street crash (and the fact that people live longer). There is barely a mention of why the economic assumptions that drive the valuation and accounting really matter. Sure, it’s not easy to explain arbitrage, present value, discounting, or the time value of money to second graders. So, instead the video makes the case for how the buck has been passed time and time again, for the children.

Bob Williams at State Budget Solutions has a nice chart that shows by how much states are underfunding their pensions. Budgets are always about tradeoffs. But not funding the pension is similar to skipping credit card payments without cutting into your daily expenses at all (or figuring out how to boost your income).

In addition, the article notes all the other ways states have of papering over deficits – floating bonds, revenue estimates, shifting dates around. This isn’t confined to the usual suspects (Illinois, New Jersey, California). There are plenty of examples to share from across the country.

The Chicago Tribunemakes a “modest proposal” this week. Discouraged by the inaction of the Illinois General Assembly on state-wide pension reform, the editorial board supports the idea that costs for teacher pensions should be shifted and shared with local governments. Republicans, fearful of property tax hikes, don’t like the notion. But the Tribune makes a good point: the cost shift should be accompanied with the ability of local governments to directly negotiate with their employees minus the influence of Springfield. It’s an interesting idea.

Ultimately, pension reform must proceed according to certain principles that clarify the following:

Right now, it’s a mess. Government accounting is a still a jumble. (But the real value is always knowable via market valuation.) No entity currently has the incentive to properly value and fund these systems. And in fact, we continue to see risk-taking and the shifting of assets into alternative investments, the issuance of Pension Obligation Bonds, and the deferral of reforms. Politicians have a short-term horizon.

And then there is the problem of “disjointed finance.”

Take the case of New Jersey. Local governments negotiate with their employees over wages. But pension policy is set by the state. New Jersey municipalities get an annual bill to fund their employee pensions based on the state actuary’s calculations. Local officials don’t have any sense of what those obligations look like going forward. The state’s annual funding calculations low-ball what is needed to fund the benefits. Could it be that such opacity leads local governments to offer wage enhancements, or hiring increases, that translate into total compensation packages that they can’t afford?

The Chicago Tribune’s idea only works if Illinois local governments accurately calculate what is needed on an annual basis to fund the pensions they negotiate with their workers and to have a full assessment of the value of compensation packages over time. How is market valuation incentivized? Perhaps Moody’s move to calculate pensions based on a corporate bond yield will have an effect. Or perhaps plans need to be managed by a third-party, as Roman Hardgrave and I suggest in our 2011 paper.

Tying local costs to local taxpayers is a good idea. Another phenomenon the pension problem has revealed is gradual separation of taxing and spending in American public finance over the course of the past half century. That has produced a growing fiscal illusion in finance – where things seem less expensive than they actually are since the costs are spread over larger groups of taxpayers. Local costs are spread among state taxpayers, and now the worry is that state pension costs and debts will be spread across national taxpayers. At least, it’s been suggested.

In his 2012 budget, Governor Quinn alluded to a federal government guarantee of Illinois’ pension debt. It’s not a popular idea with Congress at the moment. But it appears to have been part of the political calculations of those who are responsible designing and enforcing the rules that guide Illinois’ budget and determine pension policy.

California Governor Jerry Brown has led an effort to pass some changes to current state employee pension benefits that will affect new employees by raising their retirement age, capping their potential benefits, and requiring both new employees and some current workers to pay at least half of the cost of their pensions.

At Public Sector, Inc. Steve Greenhut explain that the savings from these changes won’t be felt for years to come:

It’s clear the reform would do little to touch current unfunded pension liabilities, estimated in California at as much as a half-trillion dollars, but will bring in reforms in decades after new hires start retiring.

The changes are projected to save state taxpayers between $40 billion and $60 billion. With these changes, California’s pension fund will still be underfunded by about $450 billion, calculated using the risk-free discount rate (pdf). If policymakers refuse to make further changes to the system, this remaining debt will require greater sacrifices from new workers and future taxpayers.

This unfunded liability represents generational unfairness. Today’s taxpayers are paying for current retirees who provided state services in the past. Likewise, the new reforms require sacrifices primarily from new workers. They will be receiving fewer benefits while paying into a system that benefits current workers and retirees.

States have unfunded pension liabilities due to management mistakes of the past. However, the costs of these mistakes are being felt today. Going forward policymakers should see the pain they impose on younger workers and make every effort not to repeat this pattern.

The longer that reforms are delayed, the greater inter-generational inequity grows. While California has the largest unfunded pension liability, it is not alone. Because Illinois has failed to take significant actions to address the state’s debt and pension liabilities, S&P downgraded its bond rating to A-plus with a negative outlook. This makes it S&P’s second-lowest-rated state above only California. Moody’s ranks Illinois’ bonds the lowest of all states. These ratings will be accompanied by higher bond yields on Illinois’ debt for future taxpayers. This will saddle them with more of their tax dollars going to debt service rather than current state services.

Policymakers have every incentive to engage in policies that benefit current voters at the expense of future voters because they want to receive credit for providing services that exceed their cost in the present. The only way to correct this tendency is for voters to demand that lawmakers do not force the cost of current programs onto those who do not have a voice in today’s elections.

The recession of 2008 pulled the mask off of state budget pathologies that had been identified as institutional weaknesses in the decades leading to the crisis.

The “new normal” for state and local governments does not look like the booming 1980s and 1990s but in fact is riddled with many fiscal challenges. Revenues aren’t what they were before 2008 though they are expected to reach pre-recession levels in FY 2013. The Medicaid and employee benefits bill is rising. The stimulus pushed forward budgetary reforms. These are some of the findings of the Ravitch-Volker Report, an effort of the State Budget Crisis Task Force which assembled in 2010-2012 to diagnose the major problems facing six states: California, Illinois, New Jersey, New York, Texas and Virginia.

Much of the analysis is non-controversial: Medicaid is eating up budgets, as are pensions costs and health care benefits.

Medicaid, currently at 24 percent of state spending, will continue to increase as enrollment, medical inflation and the increasing caseloads that come with higher unemployment increase costs. This is not a surprise. What is new is that the federal government is making it harder for cost-saving measure to be enacted, and “entrenched provider groups in each state resist reductions in Medicaid provider rates….” I do not believe this is the intention of the authors of the report but the diagnosis of Medicaid’s future highlights the dysfunctional aspects of this federal-state pact which has led to the creation of special interests that benefit from inflating costs.

On the pension front the Ravitch-Volker report points to the the role discount rates have played in the pension funding problems facing the state and local governments, in particular in New Jersey. And they also note the reliance on budgetary gimmicks that may even result in a kind of budgetary “cynicism.” A point I have made in the past.

But the report also makes a few assumptions about the interplay of federal, state and local spending that I think could benefit from an expanded debate. The authors warn that cuts in federal discretionary spending will doom subsidiary governments. On the surface, that’s true. Cuts in aid mean less money in state coffers for education, transportation and other areas. But the larger question is what are the fiscal effects of grants-in-aid between governments? There is the public choice literature to consider on the role of fiscal illusion in finances. And further, does the current model of delivering these services actually work as intended?

Their recommendations are largely sound. Many of them have been made before: more transparent accounting, a tightening of rainy day fund rules (see our recent paper on Illinois), broad-based tax systems should replace narrow ones, the re-establishment of the Advisory Commission on Intergovernmental Relations (ACIR). Abolished in 1995 ACIR was concerned with evaluating the fiscal impact of federal policies in the states. Further the commission recommends the federal government work with the states to help control Medicaid costs, and the re-evaluation by states of their own local needs including municipal finances and infrastructure spending.

The report is timely, contains good information and brings many challenges to the fore. But this discussion can also benefit from a larger debate over the current federal-state-local spending model which dates largely to the middle of last century. This debate is not merely about how books are balanced but how citizens are governed in our federalist system. The Ravitch-Volker report is sober but cautious in this regard. The report sketches out the fiscal picture of the U.S. in broad strokes and offers general principles for states to follow and it is sure to create discussion among policymakers in the coming months.

Money is tight for state and local governments, and that’s never more obvious than when lawmakers work to finalize budgets before the new fiscal year starts on July 1. A common priority for lawmakers, particularly in the revenue department, is to bring new business to the state. That’s why various state economic development websites claim to offer would-be-entrepreneurs the perfect set of enticements to start or expand one’s businesses.

Even on the national stage, President Obama frequently cites the need to compete with India and China in calling for more spending (or, to use his preferred phrase, “more investment”). Unfortunately, politicians often believe that the way to out-compete other governments is to undermine genuine competition at home by offering some firms and industries an uncompetitive edge.

This week, for example, the D.C. Council unanimously voted to give the daily deal company, LivingSocial, a $32,500,000 get-out-of-tax free card. Two years ago, the state of Illinois offered LivingSocial rival, Groupon, a similar though less-lucrative deal: $3,500,000 in state funds to hire 250 employees. In some industries, these types of special deals are business as usual. Film production companies, for example, can get special tax treatment in 40 out of 50 states. In Virginia, film production companies pay no sales tax on production-related products and are allowed refundable individual and corporate income tax credits. Needless to say, Virginia companies in other lines of work aren’t so lucky.

Interestingly, these types of deals are as likely to be opposed by progressives as they are to be opposed by market-oriented economists. In 2010, the left-leaning Center on Budget and Policy Priorities released a report that was critical of film subsidies. The author argued:

Like a Hollywood fantasy, claims that tax subsidies for film and TV productions — which nearly every state has adopted in recent years — are cost-effective tools of job and income creation are more fiction than fact. In the harsh light of reality, film subsidies offer little bang for the buck.

I couldn’t agree more. Back in March, I also found myself largely agreeing with the left-of-center D.C. Fiscal Policy Institute’s Ed Lazere, as we both lambasted government business incentives on the Kojo Nnamdi Show.

Though special deals for particular firms or industries are often sold in the name of competition, they are exceedingly anti-competitive. When one firm or one industry obtains a privilege from government, it obtains a measure of monopoly power. While the profits of the firm go up, so do the prices that consumers pay. And while it is harder to quantify, would-be competitors who aren’t so lucky to have government’s favor also lose. But that’s not all. Privileged firms tend to offer lower-quality products and they tend to be less-attentive to cost-cutting. Then there is the social waste associated with obtaining privileges: each year, firms expend millions of dollars on lobbying and other political activity in an attempt to obtain privilege. At the societal level, privileges undermine long-run growth and may even lead to short-term macroeconomic instability. Government-granted privileges are often dispensed on the basis of personal connection rather than merit. This, in turn, can undermine the legitimacy of both the public and the private sector. In a new paper, out soon, I document these and other problems with government-granted privilege.

There is nothing wrong with a government and its leaders attempting to compete with other governments. But the best way to compete is to offer a sound, economically free, environment in which any firm that creates value for its customers is free to prosper. It is a good indication that a government has failed to create such an environment if it feels the need to suspend or otherwise alter the rules of the game for certain favored firms and industries.

On Friday, Governor Quinn proposed the most drastic pension reforms to date in Illinois. To meet the funding gap in the pension system, which on an actuarial basis is reported at $83 billion, the Governor will offer workers a choice between higher annual contributions to the system or the loss of health care benefits and a reduced pension.

The measures reflect the growing pressure the pension system is placing on general revenues. In FY 2008 Illinois contributed six percent of its revenues to the pension system. In FY 2013, the state must contribute 15 percent of general revenues or $5.2 billion to keep the system afloat.

Employees who accept the terms will contribute 3 percent more to their pensions, have a reduced or delayed COLA upon retirement and in some cases be required to retire at age 67 (up from the current 65). However, any pay increases would continue to count for the purpose of calculating benefits. Employees who refuse the terms and continue under the current plan will lose their health care benefits and their pay increases will not count towards their pension benefit calculation.

Considering the legal framework of Illinois’ pension plan, which constitutionally guarantees workers’ pension benefits, Governor Quinn’s reforms are quite bold. The proposal offers a kind of “constitutional test” to the system and could set a legal precedent in the state for pension reform. It is a sure bet that public unions will take legal action against the measures.

If they are adopted, will Quinn’s new proposal be enough to fill the funding gap? On a market basis, Illinois’ unfunded pension liability is several times larger than reported. We calculate it is closer to $173 billion, so mathematically speaking, no. However, the plan confronts current employee costs and shows a new willingness to tackle the problem. Up until now pension reform in Illinois has only affected new hires.

Illinois Governor Pat Quinn proposed several changes to the state’s pension plan last week designed to shore up the state’s fund that has one of the nation’s largest unfunded liabilities. The Chicago Tribune summarizes the potential changes:

Illinois’ unfunded pension liability has grown to a huge $83 billion after the state skimped on funding for years. In fiscal 2013, which begins July 1, the state’s payment into the pension system will hit $5.2 billion, or 15 percent of general revenue spending – up substantially from 6 percent in 2008, according to the governor’s office.

Quinn, a Democrat, said his plan would leave the system, which covers state, local school, university and community college employees, 100 percent funded by 2042. Without it, he said Illinois will have expected payments totaling nearly $310 billion between 2012 and 2045, when a $32.7 billion unfunded liability would still remain.

“This plan rescues our pension system and allows public employees who have faithfully contributed to the system to continue to receive pension benefits,” he said.

Under the proposal, workers’ pension contributions would increase by 3 percent, while cost-of-living adjustments would be reduced. A retirement age of 67 would also be phased in.

Governor Quinn says that these changes will save state taxpayers between $65 and $85 billion in the next 30 years. The plan would also take steps to try to reduce abuse of the public sector pension system on the part of union employees that the Tribune exposed this fall.

The reforms are designed to bring the Illinois pension fund in line with the practices that the Governmental Accounting Standards Board advocates. While these reforms are marginal improvements toward putting the pension fund on a sustainable trajectory, they do not address the fundamental problem with the GASB standards. Public pensions are guaranteed benefits, so they should be valued at the risk free discount rate and invested in safe assets like US Treasury bonds. The unfunded liability is, in reality, much larger than what GASB standards suggest because they do not require the use of the risk free discount rate.

Furthermore, the reforms would do nothing to ensure that future politicians do not continue the decades of irresponsible practices that have gotten the state’s fund to where it is today. While the plan says that going forward the state will make the required contributions, we know that current legislators cannot tie the hands of future legislators. Future policymakers could easily return to skipping pension fund payments and painting a rosy picture of the funds assets with accounting gimmicks.

As Eileen and Ben point out in their paper “Illinois’s Fiscal Breaking Points,” the state needs larger institutional reforms to achieve fiscal stability and improve its bond rating. These changes could include a constitutional cap on the unfunded liability, or, better, a transition away from defined benefit public pensions to a defined contribution system.

The fifth edition of Rich States, Poor Statesfrom the American Legislative Exchange Council is now available. Utah took the top spot in the ranking of states’ economic competitiveness, as it has every year the study has been produced. Utah excels in the ranking system because it is a right-to-work state, it has a flat personal income tax, and no estate tax, among other factors considered in the study.

The other states that round out the top ten for Economic Outlook include South Dakota, Virginia, Wyoming, North Dakota, Idaho, Missouri, Colorado, Arizona, and Georgia. On the bottom end of the ranking, the states with the worst Economic Outlook are Hawaii, Maine, Illinois, Vermont, and New York at number 50 for the fourth year in a row.

The authors of Rich States, Poor States, Arthur Laffer, Stephen Moore, and Jonathan Williams demonstrate Tiebout Competition in action. They find a strong correlation between the states that have high Economic Outlook rankings with the states that are experiencing the highest population growth through domestic migration. Likewise, the states that experienced the largest losses due to out-migration include Ohio and New York, ranking 37th and 50th respectively.

The study draws attention to the role that unfunded pension liabilities play for states’ future competitiveness, as this debt will require difficult and unpopular policy decisions as current tax dollars have to be used to fund past promises. Laffer, Moore, and Williams draw a comparison between Wisconsin’s recent reforms that put it on a more sustainable path compared to its neighbor Illinois:

In stark contrast to Wisconsin’s successes, the story in Illinois is not so uplifting. Over the last 10 years, Illinois legislators have continuously ignored the pension burden in their state—so much so that Illinois has one of the worst pension systems in the nation, with an estimated unfunded liability ranging from $54 billion to $192 billion, depending on your actuarial assumptions. Furthermore, the official state estimates do not include the $17.8 billion in pension obligation bond payments that are owed. In addition, Illinois policymakers have spent beyond their means, borrowed money they don’t have, and made promises to public employee unions that they cannot fulfill. Not only did Illinois face significant unfunded pension liabilities, but also lawmakers had to confront large deficits and potential cuts to state programs.

While the policies that improve state economic competitiveness are clear, the path to achieving them is difficult after voters grow accustomed to programs that their states cannot afford. However the bitter medicine of reform is worthwhile, as we know that economic freedom is not only better for business, but evidence shows it also improves individuals’ well-being.

There was an interesting op-ed in the Chicago Tribune recently that points to the severity of Illinois’s pension mess. According to the Teachers’ Retirement System (TRS) in Illinois, if new revenues are not generated then benefits for current retirees may need to be cut via COLA reductions. This statement should not come as a surprise considering the state’s pension system is slated to run out of assets within the next decade.

As expected, however, teacher unions are unhappy with this discussion and have already deemed it unconstitutional. Unfortunately, because current benefits are protected in Illinois’s state constitution, this is a common fall back for nearly every argument against changes to the pension system.

Reducing COLA benefits may sound extreme but, as we already know, this type of reform was celebrated as a bipartisan success in Rhode Island last year. Unfortunately, during the same time, the Illinois TRS was releasing statements like this one:

The Tribune’s July 5 editorial ‘Rescuing public pensions’ is centered on the false premise that Illinois’ current pension plans for public employees are ‘doomed’ and unsustainable. The truth is that the state’s pension plans are sustainable.

One word comes to mind after reading that… scary. Illinois’s pension system is surely not sustainable. If the state continues to tell people that it is then the possibility for serious structural reform will become less likely. Reducing or suspending the COLA is one of many important steps that Illinois needs to consider.